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Europe’s Top-Down Myopia

MUNICH – The French statesman Georges Clemenceau famously remarked that, “Generals always fight the last war.” Today, in the wake of the euro crisis, the same might be said of the European Union as it seeks to put itself on a more stable institutional footing.

The EU is undergoing fundamental changes, many of which have gone largely unnoticed, owing to the overwhelming focus on large-scale top-down reforms. Officials seem not to recognize change unless it takes the form of Eurobonds, new European treaties, or policy reversals by German Chancellor Angela Merkel. But the case for small steps guided by market mechanisms is strong.

Europe’s obsession with top-down reforms is rooted in prevailing analyses of the causes of the euro crisis. Most people in Germany, the Netherlands, and Finland blame excessive public spending and inadequate regulation in countries like Greece, Spain, and Cyprus for destabilizing the eurozone and, in turn, the EU.

A somewhat more nuanced analysis holds that the euro itself is responsible for these countries’ problematic spending. The European Central Bank’s one-size-fits-all monetary policy created destabilizing imbalances in the eurozone. Interest rates were too low in Southern Europe, where governments and households binged on cheap loans, and arguably too high in Germany, which was already held back by the economic burden of reunification.

If the euro generated these imbalances, the argument goes, country-level solutions are inadequate. Europe’s only option is to repair and strengthen the currency union through banking, fiscal, and political union.

A banking union really is needed to break the vicious cycle of weak banks and debt-laden governments. The good news is that its contours are fairly clear, and the process of constructing it is already underway, though the pace is very slow.

But the logic behind fiscal union is muddier – not least because its proponents have largely failed to explain exactly what it means. The implication is that it would entail a much larger EU budget, presumably financed by some kind of EU-wide taxation, as well as eurozone-backed unemployment insurance and a debt-mutualization mechanism like Eurobonds.

The centralization of financial and fiscal powers would demand increased accountability at the European level. For that, a political union – with directly elected European officials and a significantly more powerful European Parliament – would be needed.

This is unlikely to happen, at least in the foreseeable future. But that probably does not matter as much as many people claim.

The fact is that in designing elaborate new institutions in response to the events of the last five years, there is a risk of fighting a rearguard action, rather than looking ahead to meet new challenges. After all, the eurozone crisis was rooted in the emergence of imbalances generated by the euro’s introduction and, to a lesser extent, German reunification. But neither event will happen again.

Moreover, the imbalances generated during the euro’s first decade are already being resolved. Indeed, the painful adjustments that southern European countries (and Ireland) have endured have led to substantially smaller external deficits and declining unit labor costs. Nowadays, Spain’s exports are growing faster than Germany’s. The changes that countries like Spain and Portugal are making to their labor laws, pension schemes, and regulatory systems are encouraging. These improvements will put increasing pressure on France and Italy to follow suit, which could make Europe as a whole more competitive.

Furthermore, the politics of the eurozone currently are not conducive to lasting reforms. The crisis has amplified the role of Germany – with its economic size and large external surplus – and made everyone else look weak. If Europe were to thrash out a fiscal and political union now, it would look too rigidly rules-based, too Germanic. As the rest of Europe recovers (and as Germany squanders some of its economic power by going slow on domestic reforms), Germany’s relative strength will decline. An EU without one overly dominant power could probably establish more broadly acceptable – and thus more durable – institutions.

If past problems are already being corrected, and future problems will be of a different kind and magnitude, then perhaps there is no need for Eurobonds or EU taxes. And, without debt mutualization or large-scale redistribution of wealth, political union becomes unnecessary – at least for now.

This is not to say that European institutions did not need more authority than they had before the crisis. Even without fiscal and political union, the European Commission has been empowered to supervise fiscal spending and other macroeconomic developments – such as wage growth and real-estate prices – that could cause imbalances to re-emerge.

Likewise, the ECB, together with national bodies, has gained the authority to supervise major eurozone banks. But it is also critical to recognize that financial markets have become more disciplined.

Herein lies the discrepancy between those who put their faith in institutional fixes and those who trust a more bottom-up approach. Many people, especially in the United Kingdom and the United States, seem to believe that “solving” the euro crisis means returning to the Elysian state in which all European government bonds are equally risk-free assets. But, for Germans, Dutch, and Austrians, interest-rate spreads are not the problem; they are part of the solution, given that they impose discipline that extends beyond European institutions’ new powers.

The eurozone’s new institutional framework does not have to direct 18 countries’ fiscal and economic policies. It just needs to be strong enough to enable markets to recognize and react to worrying developments, while offering real help to countries that find themselves temporarily in trouble. This is not only doable; it is being done. Now European countries can turn to the challenge of becoming more flexible and productive so that they can be more competitive in the future.

This commentary reflects the author's personal views.

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